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Financial Analysis
For PPP projects, financial analysis forms a key element of the due diligence to be
undertaken. Both the private sector and contracting authority need to know the projects
projected financial performance and for the public sector this is provided by the Stage 2
financial analysis. The analysis will also indicate whether the project needs fiscal support
and/or guarantees from Government.
Clearly, the assumptions used by the public and private parties may not/will not be the
same. This would account for the differences in the results from financial analysis. Very
likely these differences will be a basis for negotiation at a later stage.
Two commercial issues are relevant to this section, and comprise tariffs and fiscal support.
These are discussed below.
Financial analysis uses costs and revenues and is focused on assessing the project from
an investment viewpoint, usually from the point of view of the private sector or a
corporation (Sometimes referred to as a Special Purpose Vehicle or Company (SPV or
SPC)), specially created for the execution of the project.
The financial analysis is based on the standard methodology used by the private sector,
and by the public sector for private sector oriented projects, in the analysis of project
feasibility. The financial analysis uses debt service, the commercial weighted cost of
capital, the return on equity and is expressed in current terms (i.e. with inflation/
escalation). It therefore differs from the standard financial analysis used by donor
agencies and public sector.
It should be assumed, at least initially, that PPP projects will either not need any
financial support from the government, or if needed, such support will be targeted and
minimized.
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T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
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The Request for Proposals (RFP) should include the proposed index, or the proposed
tariff escalation rates, which will be allowed under the contract. Tariff escalation should
be a criterion in bidder procurement allowing bidders to compete on initial as well as
future tariffs.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
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Hence key parameters are input to the model which then produces the financial estimates
from which decisions on the PPP project can be made.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
Tariff Escalation
Tariffs and tariff escalation are normally determined to ensure a proper rate of return
based on an efficient operation. However, a subsidy may be specifically allowed by the
regulations and procedures with such funding being paid by the Government to the PPP
concessionaire based on a lower toll rate related to estimates of the users Ability to
Pay concept.
The concept of an agreed financial return incorporates several important subordinate
principles;
The need for full cost recovery (capital, operating and financing costs) if at all
possible i.e. the user pays.
The application of non-uniform tariffs (tariffs determined by project not sector).
The proposed tariff escalation also to be project based and written into the
concession agreement.
The tariff and/or subsidy, if necessary, should be determined through competitive
bidding to ensure the best deal for the user/the lowest liability for Government.
What constitutes a proper or acceptable rate of return on equity (ROE) is not specified
but might be around 18%-20% or more but would vary on a case by case and country
by country basis. The macro economic situation including inflation and returns available
in other sectors (opportunity costs) should also be included in the assessment of a fair
return.
Risks and target profit levels are directly related in that generally the lower the risk, the
lower is the private sectors target return on a project. Therefore, in assessing a fair
return to the private sector, it is critical that Government must understand this risk/
profit relationship in general and also specifically related to the subject project.
The more the risks of a project can be allocated to the best party able to bear and
mitigate them, the lower the private sectors demands for a specific return will be (More
accurately, the lower the private sectors demand for risk premiums, over and above a
risk-free return will be) and the cheaper the cost of the services provided under the
project will be.
The role of government is to negotiate a contract that neither provides for (i) more or
(ii) less than around the approximate hurdle rate of return for the specific project in
question. The former would mean too high a cost would be borne by the users and the
latter means the project will probably not be implemented.
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Therefore, Government should be clear that in trying to avoid what may be regarded as
excessive returns, it is not itself taking on unreasonable and/or excessive contingent
liabilities and risks, nor negating legitimate commercial interest in the project.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
Government must therefore be sufficiently flexible and agree to higher returns if project
or other relevant circumstances demand.
This balance should be appreciated, by Government, as being a difficult and somewhat
delicate issue on which adequate consideration (including consultation) should be
included within the pre-or full FS study.
Credit Enhancement
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The term credit enhancement is defined as taking those measures to improve the risk
and return profile of a project (which is economically viable) to attract financing so that
it will proceed to financial closure.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
The term credit enhancement may cover a variety of meanings. In principle, anything
that improves a projects bankability, may be considered credit enhancement. In broad
terms, this may include (i) a sound, credible, transparent cooperation program and (ii)
project identification and structuring which understands and addresses the concerns of
the private sector.
It may include the following three types of measures;
Typical project finance techniques. These include measures (such as escrow
accounts, mezzanine financing, and securitization) which seek to minimize
the typical types of risk found in any cooperation project. They include the
measures agreed to by the sponsors and developers (the equity participants) and
the debt participants, and usually do not directly involve the host government.
It is important, however, for the contracting authority and other agencies
of government that are involved, to be aware of and conversant with these
techniques as a part of their oversight and due diligence responsibilities in
procuring and monitoring the desired infrastructure services.
Government support. This includes a range of policies and measures (such as
off-take agreements, revenue guarantees, tax holidays) that the government can
provide to reduce the levels of risk, and improve the finances of the project, or
both, as perceived and analyzed by the PPP concessionaire, and especially the
lenders.
IFI (and Donor) support. This includes a range of instruments that IFIs and
donor agencies, such as USAID/DCA, the IFC, the ADB, OPIC, EXIM banks and other
bilateral and multilateral donors can provide to assist a country to develop its
cooperation program and bring projects to financial closure and implementation.
These typically come into force when the overall country risk is perceived to be
high (thus making purely commercial financing difficult) even though individual
projects may have sound financial and economic dynamics and deserve to be
implemented as cooperation projects.
Therefore if a project has characteristics which indicate weak or marginal financial
feasibility and/or higher than acceptable risks, the following steps would be considered
by the private sector, each with different implications for the Government, such as;
Project Costs: review/reduce costs, rephase/defer some costs
Tariff: increase proposed tariff and/or agree higher or more rapid escalation rates
Funding/ debt service improvements including seeking to reduce interest rates
or increase loan tenor (repayment period) terms (possibly in conjunction with
item 2 following)
Seek to reduce annual costs
Consider if donor support might enhance bankability partly through iii above and
consider providing some kind of fiscal support
Guidelines on government guarantees are presented in the following section.
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A typical layout of a financial model and financial template for a PPP highway project are
shown in the Module 6 -> Financial Models.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
2. In Kind Grants
3. Tax Breaks
4. Capital Contributions
4.1 Debt
4.2 Equity
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Comment
Valuation
Instrument
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
5. Guaranteed Risks
(Not under government Control)
PV of expected payouts
6. Guaranteed Risks
(Under government Control)
Same as 5. in principle
Source: Public Money for Private Infrastructure Deciding When to Offer Guarantees, Output- Based
Subsidies, and Other Fiscal Support Timothy Irwin. World Bank Working Paper No. 1
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The proposed method is appropriate for all types of fiscal support including:
Capital grant;
Minimum revenue or demand guarantee, including government-backed off-take or
power purchase agreement;
Full debt service guarantee;
Revenue rights to other infrastructure facilities;
Tax honeymoon or holiday; and
Operating subsidy.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
The method is intended primarily for the contracting agencies, as they are the best party
to take an informed view on the commercial aspects of a PPP project.
At this stage, any need for fiscal support for a PPP project needs justification by the
contracting authority. An assessment of the likely cost of the various types of fiscal
support that are considered appropriate would be required by;
The PPP cell, node or PPP unit in the relevant line ministry;
The PPP center; and
The PPP cell, node or Risk Management Unit (RMU), at a Ministry of Finance.
The assessment would assist the line ministry to decide if it would submit the evaluated
project to the central agencies. The PPP center, in turn, would then decide on the basis
of the due diligence conducted by the contracting authority whether to negotiate with
the RMU for fiscal support for the PPP project in question.
However, the RMU would make its own assessment of fiscal support, using possibly a
similar, but more sophisticated, method. Its decision would also certainly take into
consideration the governments fiscal policy and balance sheet (both present and future).
The final arbiter on providing government financial support for a PPP project is usually
a MOF.
The Method of Valuing the Future Cost of Fiscal Support
The method is based on a probabilistic model, specifically the expected utility model. It
calculates the expected cost of a particular type of fiscal contingent support in present
day (present value) terms. In order to simplify the analysis, it is assumed that the
opportunity cost of a monetary unit for all forms of fiscal support is the same.
This approach results in the estimated Present Value (PV) of the support options. Through
estimating the future (year 1 to n of the project) costs of each method of support, each
type can be brought back to PVs by using the appropriate discount rate and compared.
An Excel model can be developed to apply this model. Its application requires the
contracting authority to;
define the forecast volume of demand for each year (this is calculated as part of the
financial analysis);
define the period of fiscal support;
define the outcome scenario for each year (demand is, say 50%, 75%, 85% and
100% of forecast);
calculate the value of each outcome i.e. the amount of fiscal support; and
define the probability for the occurrence of each outcome in the scenario.
Thus, for each year there would be a number of outcomes with a probability assigned to
each outcome.
The results can be integrated into the Toolkit financial model.
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T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
Project Cost
Both
Risks
500
USD million
Length of
Concession
30
years
Projected
initial demand
90
units
Demand
Increase per
year
Demand
Risk
Price
Risk
Model
Result
123
95
28
0,05
Projected
initial Price
per unit
7.5%
Discount
Factor
0,12
Period of
Support
10
years
Year
90
102
115
129
146
165
Expected
Value of
Support per
year
USD
(b)
34
30
26
18
12
14
56
71
89
111
134
151
199
123
(a) - (b)
PV of Fiscal Support
(Both Scenarios)
USD
(10
Years)
USD
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(a)
USD
Projected
Revenue
RESULT SUMMARY
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
Base Case
0.05
0.2
0.5
0.6
Shortfall 1
0.1
0.05
0.1
0.5
0.45
0.35
Shortfall 2
0.2
0.05
0.1
0.6
0.2
0.05
0.05
Shortfall 3
0.3
0.1
0.7
0.2
0.1
Shortfall 4
0.4
0.8
0.15
0.05
Shortfall 5
0.5
0.05
1.5
Year
Base Case
0.9
0.8
0.7
0.6
0.5
Shortfall 1
0.05
0.1
0.15
0.2
0.25
0.3
Shortfall 2
0.1
0.05
0.1
0.1
0.15
Shortfall 3
0.15
0.05
0.05
Shortfall 4
0.2
Shortfall 5
0.25
0.75
Sum
RISK#1: PRICE SCENARIO
Sum
Notes:
(1) Actual Model Years is 10 but simplified for presentation.
(2) Probabilities are entered manually by user.
(3) See section 3.8 for explanation on how to use
(4) Source: Draft PPP Operational Guidelines Manual, Indonesia, 2006
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The above criteria are a useful checklist but all of these criteria must be met.
T o o l k i t f o r P u b l i c - P r i v a t e P a r t n e r s h i p s i n r o a d s & H i g h w a y s
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